Tuesday, 8 May 2012

Chances and Consequences of a Greek Default within the Eurozone

Greek politicians and journalists tend to
present a dichotomy of policy choices in terms of Greece’s future in the
Eurozone:

·
Continue austerity and remain
in the Eurozone

·
Unilateral cancellation of the
“Memorandum”, and Eurozone exit

In fact, this bilateral choice conceals the
likely course of events, which contains far more danger that what may be
apparent. I will try to describe how such a scenario would occur.

The scenario begins with either a voluntary
Greek repudiation of the lending agreement enshrined in the first and second
bail-outs, or a delay due to elections which leads to an equivalent situation.

This triggers an immediate response from
foreign creditors (private and sovereign), as follows:

· The International Monetary Fund
(IMF) ceases loan disbursements to Greece; Eurozone governments follow suit.
The immediate consequence is that Greece’s primary deficit, which in 2011 reached
EUR 7.7 billion (not counting interest payments of EUR 16 bln), must be
financed through domestic sources. On a cash flow basis, I estimate that Greece’s
primary deficit is much higher-probably at least 10-15% of GDP, or between EUR
20-30 bln.

· As a result, the government can
no longer pay pensions, government salaries, state hospital procurement or
other critical needs. Given that state worker compensation accounted for EUR
19.8 bln and social security costs were EUR 48.3 bln, we can assume that
approximately 30% of these payments will be in arrears. This means a delay of
at least 4 months in pensions and salaries, or a commensurate cut in payment
levels.

· However, this optimistic
scenario will be exacerbated by the fact that the government apparatus will
stop working, meaning that taxes will not be collected. Companies and
individuals will stop paying taxes, wages and suppliers due to the political
uncertainty.

· Greece’s private sector
creditors will immediately launch legal proceedings to recover their loans.
This will lead to yet further expenditure, but will also mean that Greek
companies will be cut off from international credit. Expect to see Greek government assets seized. This will exacerbate an
already uncontrolled crisis, particularly in areas such as agriculture and
tourism.

· In order to prevent a banking
panic, the government will have to freeze bank account deposits. This will
primarily affect the poorer, less-informed depositors: the more mobile,
well-informed companies and managers will already be informed in advance of
such a move, and will take steps to withdraw their deposits much earlier. This
means that a weekly withdrawal limit will be in effect, while international
transfers will probably be banned or subject to a large-scale withholding tax.

· Despite these efforts, the Greek
banking system will be faced by collapse in any case. Its operation today
depends on access to ECB credit lines and Bail-out II funds. Greek banks will
be cut off from both. They will be technically insolvent, and will have to be
nationalised and amalgamated. This will create significant popular and
political resistance.

· Foreign investment in Greece
will cease. Most companies will default on debt to suppliers. Many companies
will shutter or idle operations. Foreign tour operators will transfer bookings
to other sun-sea-sand destinations. Ferries and airlines will cease operations
because they won’t be able to cover their fuel costs. Imports to Greece will
only be sold on a cash-first basis.

· Greece will suffer
international outrage as the country that broke every single one of its
promises, causing a major loss of taxpayer money in other Eurozone countries.
The political consequences at the European level will be intense. Greek
politicians should not convince themselves that it will be business as usual.
Greek representatives will be excluded from meetings and decision-making. An
embargo similar to that which Austria faced over the Joerg Haider government
participation may be implemented. A freeze on EU structural funds will likely
occur.

These are the short-term impacts that will
occur within 2 weeks of an uncontrolled default. Depending on the political
situation, Greece’s next step may be to voluntarily withdraw from the Eurozone.
This will involve:

· A mandatory conversion of all
salaries and loans into a “New Drachma”, which will immediately lose between
35-40% of its value against the Euro and US Dollar.

· Bank nationalisation and strict
limits on hard currency deposits as well as withdrawals or foreign transfers.

· Inflation will shoot up between
25-30% in the best case within 1 month. Greece imports a large number of products,
ranging from food staples (meat, dairy products, vegetables) to fuel to
consumer durables and fast-moving consumer goods. These will continue to be
denominated in hard currency, while people will have to convert New Drachma at
a devalued exchange rate.

· All loans will be benchmarked
at a floating rate against the Euro. This means that as the New Drachma
devalues, families with mortgages or loans will have to pay increasingly more
of their salaries to service their loans, at the very time when inflation is
(a) making the loan appreciate at unprecedented rates, and (b) causing a
dramatic loss of purchasing power for basic household goods.

· As assets rapidly devalue,
desperate families will put property and other goods on the market at
dramatically reduced prices. This will lead to a downward spiral on asset
values that will take 2-3 years to work through.

· Unemployment will rise to over
35% as companies close, unable to cope with the new inflationary environment,
and unable to pay for inputs and working capital.

· The rate of business closures
will accelerate to depression-scale proportions.

· Mass migration will have to
occur, as younger people and others emigrate in search of stability elsewhere.

In fact, I consider a Eurozone exit
irrelevant. There is no benefit for either the Eurozone or Greece which could
not be achieved by alternative means. The idea of devaluing to regain
competitiveness will be far more painful that people imagine, particularly
given the problem of existing Euro-denominated loans. A Greek default within
the Eurozone is looking increasingly likely for this very reason.

However, having made one mistake of
historical proportions, there is absolutely nothing to say that a second
mistake will not be made.

Unfortunately, the first mistake alone will be sufficient to set off an economic firestorm of unprecedented dimensions
for Greece. No amount of political debate or advertising will be enough to
conceal this. Yet it is precisely this scenario which is now rapidly unfolding,
and may occur by June absent a firm decision on continuing the austerity
measures and the loan conditionality.

3 comments:

I've been following your blog for the past couple of weeks! The posts are always very informative and in harmony with my opinion. It's really sad how a nation that comes from great people and even greater history is in such a state right now. The attitude is often annoying, but one who lives in the middle of all this, tries to ignore it and wishes that things will somehow fall back into their places and everything will be back to normal ...

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